What Exactly Happened at Autonomy?

Today’s bombshell from Hewlett-Packard concerning an $8.8 billion write-down related to Autonomy, the British software firm it acquired in 2011 for $11.7 billion in combined cash and assumed debt, is a little hard to understand. Here’s how it breaks down:

First, HP’s total $8.8 billion write-down isn’t all Autonomy-related. Of that total amount, about $5 billion relates specifically to Autonomy. Moments ago, on a conference call with reporters, HP CFO Cathie Lesjak said that the rest stems from the drop in HP’s share price.

The core allegation is that people at Autonomy took certain accounting actions while still running Autonomy as a publicly held company in the U.K., which had the end effect of making Autonomy seem more valuable than it was. As CEO Meg Whitman put it on a conference call a few minutes ago: “There appears to have been a wilfull effort on the part of certain former Autonomy employees to inflate the underlying financials of the company in order to mislead investors and potential buyers.”

It’s important to note that Autonomy’s founder and former CEO Mike Lynch has just issued a statement, essentially denying HP’s claims. I heard portions of the statement read on CNBC. In a statement being reported by Reuters, he has “flatly rejected” HP’s allegations. Also: “HP’s due diligence review was intensive, overseen on behalf of HP by KPMG, Barclays and Perella Weinberg. HP’s senior management has also been closely involved with running Autonomy for the past year.”

So what is alleged to have happened? For one thing, Autonomy, as HP tells it, was selling some hardware at a loss. During a period of about eight quarters prior to HP’s acquisition, Autonomy sold some hardware products that had a very low margin or on which it may have even taken a loss. It then allegedly turned around and booked those hardware sales as high-margin software sales. At least some portion of the cost on these products, Whitman said, was booked as a marketing expense, not as cost of goods sold.

There’s a second piece of the puzzle, where HP says that Autonomy was selling software to value-added resellers — the middlemen in so many technology transactions — in which there are ultimately no end users. That, too, inflated apparent revenue.

Third, there were some long-term hosting deals — essentially, Autonomy hosting applications for its customers on a subscription basis — that were converted to short-term licensing deals. Future revenue for software subscriptions — that should have been deferred or recorded as coming in the future but not yet booked — were stripped out and booked all at once.

John Schultz, HP’s general counsel, said there appeared to be what he called “a conscious effort by some former Autonomy employees to portray it as a pure software company.” The low-margin or loss-making hardware sales in particular, he said on the conference call, amounted to as much as 10 percent to 15 percent of Autonomy’s revenue during the eight-quarter period in question.

It had the effect, Schultz said, of not only closing the gap between actual financial growth and the consensus expectation of analysts — meeting the consensus is always a concern at a publicly held company — but also inflated the “growth metrics” of the company. “From an accounting perspective, there were improprieties, but also there were severe disclosure failures,” he said.

Lesjak said the problems are not only with the fact that revenue was inflated by itself, but the kinds of revenue. “These hardware sales were frequently reported as licenses. The VAR sales were reported as licenses, and they weren’t, in some sense, real sales, because there was no end user.”

The result, Lesjak said, was that Autonomy was able to boost its gross margins, a key measurement of profitability. Where Autonomy had been reporting gross margins in the neighborhood of 40 percent to 45 percent, Lesjak said a more realistic gross margin at Autonomy going forward is in the 28 percent to 30 percent range.

So what is HP going to do about it? First, it has reported the matter to the enforcement division of the U.S. Securities and Exchange Commission, and to the Serious Fraud Office in the U.K. Once those authorities have their say, HP will likely sue someone. Whitman conceded that it will likely take years before it’s all done. It’s going to get ugly before it’s over.

The Wall Street Journal just got a statement from former HP CEO Léo Apotheker, who did the Autonomy deal during his 11-month tenure as CEO. In a word, he says he’s “stunned.” He will also make himself available to help HP get to the bottom of it all.

Whitman was just on CNBC for several minutes, going through the particulars and reiterating much of what she said on the conference call with reporters. Here’s the video:

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